Archive for November, 2009

Final Instalment of the Review of the US Monetary System

Economists assume we all want more money. This makes analysis of their data easier. It seems to me this simplifying assumption creates misunderstanding. Money is important to the extent that it provides the things we want. While some may want the largest accumulation, most users of money don’t see simple accumulation as satisfying a higher order need. However they are concerned that they may run out. They want to ensure that their lifestyles are protected. They would like to have some financial flexibility if events don’t unfold as expected. Hording and having “the most” is usually not top of mind for consumers in general.

Users of money are concerned with purchasing power and therefore, perhaps indirectly, inflation – and rightly so. The rate of US inflation in the past 50 years has averaged about 3.3% per year. Today’s dollar has the same buying power as 8 cents in 1929 money. In the past 15 years, purchasing power of the dollar has dropped to 67 cents. By comparison, Canadian inflation has been higher in the seventies and eighties, somewhat lower since. But how have consumers generally faired in North America?

Behavioural finance is increasingly interested in relative personal consumption expenditures (PCE). The chart below suggests a strong relationship between real disposable personal income (DPI) and real consumption. This chart illustrates an inflation adjusted income of $5,000 in 1929 continues to be worth $5,000 today. Currency in this example is held constant at year 2000 levels so that the average gain in consumption to 2008 for an American is a real $22,000 (27,000-5,000). This equates to a 2% real gain in spending power each year. If you simply kept up with inflation, you would be able to consume only 20% of the amount of your neighbours and keeping up with the Joneses would become impossible.

Per Capita Real Disposable Personal Income (DPI) and Personal Consumption Expenditures (PCE) 1929-2008

North American consumers have done very well. But what has been the source of the excess buying power? Some of the gains are the result of increased wages. The attribution of wage increases can include such things as better labour participation rates and higher education levels leading to better paying jobs. Investment gains have also contributed to higher disposable incomes. Below is a review of excess returns to the public investment markets. These are positive returns after removing inflation and PCE changes of about 2% per year.

Improvements in living standards are a good thing. But people who don’t fully participate in the growth can quickly start to feel left behind. Fully diversified fixed income investments have generally reduced disposable income. An investment in a fully diversified stock portfolio has added to disposable income.  Taxes, fees and concentrated portfolios with higher volatility have probably reduced the benefits to consumers of this affect. Since diversification reduces volatility a sensible approach would include both stocks and bonds in the mix.

Patrick

A review of the US monetary System – Suppliers, Dealers and Users

As Children, we should all be taught to aspire to own a commercial bank (dealer). Dealers have a very interesting and sustainable business model. Essentially, they lend money they don’t have, which creates money in the hands of the borrower. This “miracle of capitalism” is created by the fractional reserve system of the Federal Reserve. The interest paid on these loans is earnings for the commercial bank. The leverage to assets is big; the Fed requires a 10 percent reserve so that a commercial bank can loan up to ten times its asset base.

In the US, commercial banks and investment banks were divided by the Glass-Steagall Act of 1933.  After the depression is was thought that risky investment banking activities needed to be separate from the Fed-backed activities of commercial banks. Glass-Steagall also introduced deposit insurance on deposits (FDIC), further protecting the interests of depositors. The act (not FDIC) was repealed in 1999 in an effort to allow US dealers to compete on a level field with Great Britain. Margaret Thatcher’s “big bang” deregulated the UK financial system in 1986. Canada followed in the late 1980s and dissolved the restrictions for commercial and investment bank mergers. Trust companies were also deregulated. Insurance companies maintained some of their independence though Canada’s big 6 retail banks are finding ways to capture market share in the insurance business as well.

Given the extremely low cost of capital and advantaged position banks share with respect to the Fed, it is difficult to compete with dealers as a group.

The promise of Big Bang and deregulation was reduced cost of capital for customers. In addition, reduction of regulatory involvement was seen as a method of increasing competition and innovation by combining access to debt and equity capabilities. Stanley Hartt, deputy Minister of Finance for Canada 1985-88 summarizes the view at that time as “the banks felt they had to grow to survive”.

These conclusions have been greatly challenged by the financial crises of 2008-09.  Leading up to the Fall of 2008, one stop financial supermarkets were able to securitize debt, selling it off to institutional investors to raise additional cash assets. This in turn allowed for more leverage to earnings and more risk assumed. The system was clearly out of equilibrium. In September 2008, perhaps precipitated by the collapse of Lehman Brothers, the system froze. Banks would no longer lend to one another for fear of undisclosed liabilities (non-visibility) reducing the real credit worthiness of the borrowing parties and increasing the likelihood of default.

Big isn’t better, and in some cases as we have recently experienced, it is much worse. Canadian banks have faired better than most. A major contributing factor is that they didn’t get their wish about eliminating foreign ownership restrictions.  Canadian banks are limited to 10% foreign ownership. It seems to me that as a group they should be grateful for the failure in their lobby effort to have that restriction eliminated. It saved their asset base and our banks and protected them from much more of the downside of the credit crises of 2008-09. Instead, in 2009 the Canadian economy and financial system has experienced strong relative growth compared to the international competition.

Commercial banks are too big to fail because of the unique arrangement they have with taxpayers. FDIC (CDIC in Canada) insures assets to 250k (100k). If they default, the government, backed by tax revenues, guarantees the liability. This call on tax dollars creates an incentive to accept more risk, in an effort to maximize shareholder profit, since Banks are credited with the positive return to risk but are insured for losses.

For banks it is very unlikely if not impossible to reorganize under bankruptcy protection. Unlike other corporations like airlines, for banks bankruptcy is equal to liquidation.

Clearly there is something wrong with this system. The old idea of building scale to eliminate the competition appears to be in conflict with the best interests of the economy as a whole.

We could try to use a 1930s solution and disentangle commercial banks and investment banks or perhaps more realistically, the consequences of bank failures could be minimized. To my thinking the latter approach is more likely. New regulation can be introduced to reduce potential claims on taxpayers.

A group has been formed to provide recommendations on just that line of thinking. The Squam Lake Working Group on Financial Regulation is a group comprised of 15 leading academics who want to bring the system back into equilibrium. The thinking is that if the incentives of scale are reduced and the costs to society of banks failures are minimized, then a better equilibrium will be established for the financial system and by extension, the economy as a whole. The group had developed several practical solutions to improve the systemic problems. It appears the US administration is listening.